Capital Budgeting: Understanding the Payback Period Method

The process of capital budgeting is designed to help businesses make decisions on future projects. One method of capital budgeting uses a payback period to help make these decisions. Here are the basics of the payback period and whether you should use it in capital budgeting for your business.

Payback Period

The basic idea behind this method is to choose the project whose initial investment will be paid back in the shortest time. In order to calculate this, you take the cost of each potential project and divide it by the annual inflow of cash it will bring. This will tell you how many years it would take to recover the initial investment. For example, let's say that you have a project that will cost $100,000 and it will bring in $20,000 per year. The payback period for this project is five years. Compare the payback periods for your potential projects. Then choose the investment that would pay back in the shortest amount of time and move forward with it.

Using This Method

The main benefit of this method of capital budgeting is that it is very simple. It does not take much calculation and can be done quickly. However, it fails to consider anything past the initial payback period and, therefore, could be considered unreliable.